The Dangers of Trying to Time the Market

How many times have you heard that “buy low, sell high” is the key to amassing a fortune on the stock market?

It certainly seems like common sense to buy something at its lowest price and then sell it when prices peak. But while the mantra of “buy low, sell high” sounds good in theory, in the real world it can be a recipe for disaster, especially when practiced by beginners.

The problem with trying to time the market is that no one knows with any certainty what the market will do. Even institutional investors who manage hundreds of millions of dollars and have access to all sorts of sophisticated investing tools can’t consistently predict what the stock market will do.

What hope does an individual investor like you or me have?

Timing the Market – Easier Said Than Done

Back in 2008, I was working nights at Babies R Us to supplement my income. One night in early October I walked into the back room and my buddy Dom asked me if I heard the news about the stock market.

Who hadn’t?

On September 29, 2008 the Dow Jones Industrial Average had dropped nearly 778 points in a single day. Over the next two weeks the DJIA would continue to fall as investors panicked over the housing bubble and banking scandals.

From September 29 through October 10, the Dow Jones dropped from 11,143.13 to 8,451.19…an astonishing drop of 2,691.94 points in just two weeks. As we stocked a fresh batch of baby monitors onto the shelves, Dom told me he was afraid that his entire 401(k) balance would evaporate and he was moving all his money out of stocks and into money market funds.

Seeing your account balance drop almost 25 percent in a matter of weeks is enough to scare anyone, but was withdrawing from the market really a good idea?

First let’s look at what the Dow has done since those dark days and then we’ll run some numbers to see what would happen to a hypothetical portfolio.

The chart below comes courtesy of Google Finance and it shows the history of the Dow Jones from August 1, 2008 (two months before the crash began) through April 12, 2013. As you can see the DJIA was flirting with the 12,000 mark when the bottom suddenly fell out of the market in early October.

The Dow drops off a cliff but recoups all the losses and then some.

It dropped fast and furious over the next few months until hitting bottom on March 9, 2009 when it closed at 6,547.01. Since hitting that low mark the stock market began a long, slow march upwards. It took some time, but the Dow Jones eventually recouped all it had lost and then some.

A closer look as the Dow drops 4600 points in 5 months before bouncing back.

In hindsight, the best thing an investor could have done would be to sell everything on September 26, 2008 and then buy back in just as the market hit its lowest point on March 9, 2009. Of course, the only way to accurately predict those dates is if you have access to a crystal ball or Marty McFly’s DeLorean.

In reality, here’s a much more likely scenario.

Let’s start with a nice round number and say that when the market closed on September 26 at 11,143.13 you had exactly $100,000 invested in the market and your portfolio exactly matches the Dow.

Like pretty much everyone else, you never saw the crash coming. By the time you were able to figure out what was happening and sell off your positions the Dow was down to 8,400. You just lost 24.6 percent of your portfolio and you now have only $75,400.

As the months go by and the market drops below 7,000 you count your blessings and shake your head at all the fools who chose to stick it out. But then the market turns around and starts to rise. Wary of another downturn you wait to see if the gains will hold up and by the time you’re confident enough to re-enter the market 2009 is coming to an end and the Dow Jones is back up to 10,500. You’ve already missed out on much of the rebound, but even so you would have earned a nifty 41.5 percent return as the market bounced back to its current level of 14,865.06 as of April 12, 2013. At that rate of return you’d now have $106,745.29.

But what if you had done nothing and left your money in the market? Your original $100,000 investment would be worth over $133,000 today!

Even though your portfolio would have absorbed greater losses as the market dropped, you would have enjoyed all the gains as the market roared back on its way to record highs.

Also, those who retreated from the market only to re-enter later would have paid broker commissions when they sold off their positions and again when they bought back in. Those additional expenses would have further eaten into their return.

In the end, those who had the discipline to stay the course and weather the storm probably made out better than those who panicked and sold off as the market tumbled.

Ask yourself…did the people who sold their positions do so because they made a rational decision that the stock market no longer fit into their long-term plans? Or did they do it out of panic?

Separating your emotions from your money choices is not always possible. After all, we’re not robots.

Perhaps the key is to recognize that your emotions will affect your decisions and take a moment or two to question whether or not your emotions are about to lead you astray.

Readers, what do you think? Is timing the market possible or are you better off staying the course through hard times? Have you ever made an emotional decision that you later regretted?

Mike is a freelance writer and blogger who specializes in finance and parenting topics. He is a dedicated husband and father of three who is obsessed with creating multiple streams of income and building wealth so he can achieve true financial freedom for his family. Like what you're reading? Subscribe to our free RSS feed and follow us on Twitter.

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Comments

To be honest, I don’t know if I can remain calm during financial crisis, but I know that during crisis it’s really make or break for investors. So I guess, I’ll just convince myself that cost averaging will always work most especially during crisis as long as I’m invested in blue chip companies.

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